Financial Ratios

Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely on current asset and current liability amounts appearing on a company's balance sheet:

Financial Ratio		How to Calculate It	What It Tells You
Working Capital	= = =	Current Assets – Current Liabilities $89,000 – $61,000 $28,000	An indicator of whether the company will be able to meet its current obligations (pay its bills, meet its payroll, make a loan payment, etc.) If a company has current assets exactly equal to current liabilities, it has no working capital. The greater the amount of working capital the more likely it will be able to make its payments on time.
Current Ratio	= = =	Current Assets ÷ Current Liabilities $89,000 ÷ $61,000 1.46	This tells you the relationship of current assets to current liabilities. A ratio of 3:1 is better than 2:1. A 1:1 ratio means there is no working capital.
Quick Ratio (Acid Test Ratio)	= = = =	[(Cash + Temp. Investments + Accounts Receivable) ÷ Current Liabilities] : 1 [($2,100 + $100 + $10,000 + $40,500) ÷ $61,000] : 1 [$52,700 ÷ $61,000] : 1 0.86 : 1	This ratio is similar to the current ratio except that Inventory, Supplies, and Prepaid Expenses are excluded. This indicates the relationship between the amount of assets that can quickly be turned into cash versus the amount of current liabilities.

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to income statement amounts. To illustrate these financial ratios we will use the following income statement information:

Example Corporation Income Statement For the year ended December 31, 2007 Sales (all on credit) $500,000 Cost of Goods Sold   380,000 Gross Profit   120,000 Operating Expenses Selling Expenses 35,000 Administrative Expenses    45,000 Total Operating Expenses    80,000 Operating Income 40,000 Interest Expense    12,000 Income before Taxes 28,000 Income Tax Expense     5,000 Net Income after Taxes $ 23,000

(To learn more about the income statement, go to Explanation of Income Statement, Drills for Income Statement, and Crossword Puzzle for Income Statement.)

Financial Ratio		How to Calculate It	What It Tells You
Accounts Receivable Turnover	= = =	Net Credit Sales for the Year ÷ Average Accounts Receivable for the Year $500,000 ÷ $42,000 (a computed average) 11.90	The number of times per year that the accounts receivables turn over. Keep in mind that the result is an average, since credit sales and accounts receivable are likely to fluctuate during the year. It is important to use the average balance of accounts receivable during the year.
Days' Sales in Accounts Receivable	= = =	365 days in Year ÷ Accounts Receivable Turnover in Year 365 days ÷ 11.90 30.67 days	The average number of days that it took to collect the average amount of accounts receivable during the year. This statistic is only as good as the Accounts Receivable Turnover figure.
Inventory Turnover	= = =	Cost of Goods Sold for the Year ÷ Average Inventory for the Year $380,000 ÷ $30,000 (a computed average) 12.67	The number of times per year that Inventory turns over. Keep in mind that the result is an average, since sales and inventory levels are likely to fluctuate during the year. Since inventory is at cost (not sales value), it is important to use the Cost of Goods Sold. Also be sure to use the average balance of inventory during the year.
Days' Sales in Inventory	= = =	365 days in Year ÷ Inventory Turnover in Year 365 days ÷ 12.67 28.81	The average number of days that it took to sell the average inventory during the year. This statistic is only as good as the Inventory Turnover figure.

The next financial ratio involves the relationship between two amounts from the balance sheet: total liabilities and total stockholders' equity:

Financial Ratio		How to Calculate It	What It Tells You
Debt to Equity	= = =	(Total liabilities ÷ Total Stockholders' Equity) : 1 ( $481,000 ÷ $289,000) : 1 1.66 : 1	The proportion of a company's assets supplied by the company's creditors versus the amount supplied the owner or stockholders. In this example the creditors have supplied $1.66 for each $1.00 supplied by the stockholders.

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